Korte SV Corporate finance and governance
1. Debt policies
Financing a Firm with Debt and Equity
• Modigliani and Miller argued that with “perfect” capital markets, the total value of a firm
should not depend on how it is financed
o Assumption M&M:
- No taxes, transaction costs, or issuance costs associated with security trading and
- A firm’s financing decisions has no impact on the cash flows generated by its
investments + it does not provide information on the value of these investments
• Debt is cheaper than equity for a firm, BUT it raises the cost of capital for equity
• Levered equity has higher risk (even when there is no risk that the firm will default)
o To compensate for this risk, more levered equity holders receive a higher expected return
• Leverage will not affect the total value of the firm*, it merely changes the allocation of cash flows
between debt and equity
o debt increase leads to cost of capital/equity increases: higher equity risk & higher required
return ➜ together: debt increase will not affect the cost of capital*
1) Modigliani-Miller Proposition I
• In a perfect capital market, the total value of a firm (or the value per share) is equal to the market
value of the total CF’s generated by its assets, and is not affected by its choice of capital structure
• Application: A Leveraged Recapitalization
• In a Modigliani & Miller world, this will not affect the value of the firm!
• First, Harrison sells debt to raise $80 million in cash / issuing debt (bonds) & then they use
the cash to repurchase shares
•
80 mil / 4 = 20 mil
shares repurchased
➜ 50 - 20 = 30
OR
120/4 = 30
➜ change in capital structure (increase in leverage), doesn’t affect the value for shareholders
2) Modigliani-Miller Proposition II
• Total cost of capital is not influenced by the capital structure & therefore always equals the
unlevered cost of capital (= 100% equity)
• MM Proposition I states that: E + D = U = A
– E: Market value of equity in a levered firm.
– D: Market value of debt in a levered firm.
– U: Market value of equity in an unlevered firm (100% equity)
– A: Market value of the firm’s assets
➜ Total cost of capital = weighted average of cost of debt & equity
1
,• take on more Debt? ➜ cost of E increase (more risk)
o how much? RE = RU + D/E(RU – RD)
o more cheap D (low RD gets more weight)
➜ Total cost of capital remains the same (= weighted average of cost of E & cost of D)
• Leverage and the Equity Cost of Capital
– The return on unlevered equity (RU) is related to the returns of levered equity (RE) and debt (RD):
o
o
➜ The levered equity return equals the unlevered
return, plus a premium due to leverage.
o more debt? ➜ premium bigger (D/E * …) ; higher return on equity (RE)
– MM Proposition II: The cost of capital of levered equity is equal to the cost of capital of
unlevered equity plus a premium that is proportional to the market value debt-equity ratio
o Cost of Capital of Levered Equity:
The Weighted Average Cost of Capital (WACC)
• If a firm is levered, rA is equal to the firm’s weighted average cost of capital
•
➜
Levered and Unlevered Betas
• The effect of leverage on the risk of a firm’s securities can also be expressed in terms of beta:
o Unlevered Beta: a measure of the risk of a firm as if it did not have leverage, which is
equivalent to the beta of the firm’s assets (weighted average of the β if equity & debt)
• CAPM= only systemic risk (=β) matters (other risks can be diversified away)
•
o Leverage amplifies the market risk of a firm’s assets, βU , raising the market risk of its equity
➜ risk for shareholders depends on:
1) firm activities (βU)
2) firm debt policy: debt rises; risk shareholders (βE) rises (D/E)
2
,Cash and Net Debt
• Holding cash has the opposite effect of leverage on risk and return and can be viewed as equivalent
to negative debt.
o Net Debt = Debt - Cash & Risk-Free Securities
-Debt: pay a fixed interest & Cash: earn a fixed interest
•
o negative net debt of -$16 bln
o
- βU > βE ➜ very unusual
o risk of operations higher than risk of equity because of negative net debt
o (βE = 2,57 + (-16/110)*(2,57-0) = 2,20)
Equity Issuances and Dilution
• Dilution: an increase in the total of shares that will divide a fixed amount of earnings
➜ this will lower the value per share
➜ in the context of the theory of M&M, that reasoning is wrong: total value will increase as well
• Example: o Tesla issued new shares, raised new equity
o Jet Sky Airlines (JSA) currently has no debt & 500 million shares of stock outstanding
o
= Value of the firm
• Results: The market value of JSA’s assets grows because of the additional $1 billion
in cash the firm has raised & number of shares increases ➜ VPS stays equal
• As long as the firm sells the new shares of equity at a fair price (reflects the true value), there will
be no gain or loss to already existing shareholders associated with the equity issue itself!
• Why then does the stock price so often decrease when an equity issuance is announced?
o stock at a high price? Perfect time for equity issuance: raise lots of money
➜ shareholders can see an equity issuance as a sign that the stock is overvalued; sell;
price decreases
FROM THIS PART: WE ADD IMPERFECTIONS
3
, The Interest Tax Deduction
• In the real world, interest payments are deductible from taxable corporate income!
• Example: Safeway, Inc.
o EBIT = $1.25 billion, Interest expenses = $400 million & Marginal corporate tax rate = 35
o
Difference = intrest tax shield
= 400*35% = 140
>
Not deductable? Taxes still 438;
net income 1250 – 400 – 438 = 412 ; +400 = 812
The Interest Tax Deduction
• Interest Tax Shield: the reduction in taxes paid due to the tax deductibility of interest
o In Safeway’s case, the gain is equal to the reduction in taxes with leverage: $438 million −
$298 million = $140 million. The interest payments provided a tax savings of 35% × $400
million = $140 million.
o The Cash Flows of the Unlevered and Levered Firm:
The Interest Tax Shield and Firm Value
• MM Proposition I with Taxes (total value if leverage )
o VL = VU + PV (Interest Tax Shield)
The Weighted Average Cost of Capital with Taxes
• Proposition II: WACC if leverage
• With tax-deductible interest, the effective after tax borrowing rate is r(1 − c ) and the weighted
average cost of capital becomes:
The WACC with and without Corporate Taxes:
Constant across capital
structures/leverage
WACC with
4
decreases, incentive
to go for 100% debt
1. Debt policies
Financing a Firm with Debt and Equity
• Modigliani and Miller argued that with “perfect” capital markets, the total value of a firm
should not depend on how it is financed
o Assumption M&M:
- No taxes, transaction costs, or issuance costs associated with security trading and
- A firm’s financing decisions has no impact on the cash flows generated by its
investments + it does not provide information on the value of these investments
• Debt is cheaper than equity for a firm, BUT it raises the cost of capital for equity
• Levered equity has higher risk (even when there is no risk that the firm will default)
o To compensate for this risk, more levered equity holders receive a higher expected return
• Leverage will not affect the total value of the firm*, it merely changes the allocation of cash flows
between debt and equity
o debt increase leads to cost of capital/equity increases: higher equity risk & higher required
return ➜ together: debt increase will not affect the cost of capital*
1) Modigliani-Miller Proposition I
• In a perfect capital market, the total value of a firm (or the value per share) is equal to the market
value of the total CF’s generated by its assets, and is not affected by its choice of capital structure
• Application: A Leveraged Recapitalization
• In a Modigliani & Miller world, this will not affect the value of the firm!
• First, Harrison sells debt to raise $80 million in cash / issuing debt (bonds) & then they use
the cash to repurchase shares
•
80 mil / 4 = 20 mil
shares repurchased
➜ 50 - 20 = 30
OR
120/4 = 30
➜ change in capital structure (increase in leverage), doesn’t affect the value for shareholders
2) Modigliani-Miller Proposition II
• Total cost of capital is not influenced by the capital structure & therefore always equals the
unlevered cost of capital (= 100% equity)
• MM Proposition I states that: E + D = U = A
– E: Market value of equity in a levered firm.
– D: Market value of debt in a levered firm.
– U: Market value of equity in an unlevered firm (100% equity)
– A: Market value of the firm’s assets
➜ Total cost of capital = weighted average of cost of debt & equity
1
,• take on more Debt? ➜ cost of E increase (more risk)
o how much? RE = RU + D/E(RU – RD)
o more cheap D (low RD gets more weight)
➜ Total cost of capital remains the same (= weighted average of cost of E & cost of D)
• Leverage and the Equity Cost of Capital
– The return on unlevered equity (RU) is related to the returns of levered equity (RE) and debt (RD):
o
o
➜ The levered equity return equals the unlevered
return, plus a premium due to leverage.
o more debt? ➜ premium bigger (D/E * …) ; higher return on equity (RE)
– MM Proposition II: The cost of capital of levered equity is equal to the cost of capital of
unlevered equity plus a premium that is proportional to the market value debt-equity ratio
o Cost of Capital of Levered Equity:
The Weighted Average Cost of Capital (WACC)
• If a firm is levered, rA is equal to the firm’s weighted average cost of capital
•
➜
Levered and Unlevered Betas
• The effect of leverage on the risk of a firm’s securities can also be expressed in terms of beta:
o Unlevered Beta: a measure of the risk of a firm as if it did not have leverage, which is
equivalent to the beta of the firm’s assets (weighted average of the β if equity & debt)
• CAPM= only systemic risk (=β) matters (other risks can be diversified away)
•
o Leverage amplifies the market risk of a firm’s assets, βU , raising the market risk of its equity
➜ risk for shareholders depends on:
1) firm activities (βU)
2) firm debt policy: debt rises; risk shareholders (βE) rises (D/E)
2
,Cash and Net Debt
• Holding cash has the opposite effect of leverage on risk and return and can be viewed as equivalent
to negative debt.
o Net Debt = Debt - Cash & Risk-Free Securities
-Debt: pay a fixed interest & Cash: earn a fixed interest
•
o negative net debt of -$16 bln
o
- βU > βE ➜ very unusual
o risk of operations higher than risk of equity because of negative net debt
o (βE = 2,57 + (-16/110)*(2,57-0) = 2,20)
Equity Issuances and Dilution
• Dilution: an increase in the total of shares that will divide a fixed amount of earnings
➜ this will lower the value per share
➜ in the context of the theory of M&M, that reasoning is wrong: total value will increase as well
• Example: o Tesla issued new shares, raised new equity
o Jet Sky Airlines (JSA) currently has no debt & 500 million shares of stock outstanding
o
= Value of the firm
• Results: The market value of JSA’s assets grows because of the additional $1 billion
in cash the firm has raised & number of shares increases ➜ VPS stays equal
• As long as the firm sells the new shares of equity at a fair price (reflects the true value), there will
be no gain or loss to already existing shareholders associated with the equity issue itself!
• Why then does the stock price so often decrease when an equity issuance is announced?
o stock at a high price? Perfect time for equity issuance: raise lots of money
➜ shareholders can see an equity issuance as a sign that the stock is overvalued; sell;
price decreases
FROM THIS PART: WE ADD IMPERFECTIONS
3
, The Interest Tax Deduction
• In the real world, interest payments are deductible from taxable corporate income!
• Example: Safeway, Inc.
o EBIT = $1.25 billion, Interest expenses = $400 million & Marginal corporate tax rate = 35
o
Difference = intrest tax shield
= 400*35% = 140
>
Not deductable? Taxes still 438;
net income 1250 – 400 – 438 = 412 ; +400 = 812
The Interest Tax Deduction
• Interest Tax Shield: the reduction in taxes paid due to the tax deductibility of interest
o In Safeway’s case, the gain is equal to the reduction in taxes with leverage: $438 million −
$298 million = $140 million. The interest payments provided a tax savings of 35% × $400
million = $140 million.
o The Cash Flows of the Unlevered and Levered Firm:
The Interest Tax Shield and Firm Value
• MM Proposition I with Taxes (total value if leverage )
o VL = VU + PV (Interest Tax Shield)
The Weighted Average Cost of Capital with Taxes
• Proposition II: WACC if leverage
• With tax-deductible interest, the effective after tax borrowing rate is r(1 − c ) and the weighted
average cost of capital becomes:
The WACC with and without Corporate Taxes:
Constant across capital
structures/leverage
WACC with
4
decreases, incentive
to go for 100% debt
